What The Velocity Of Money Tells Us About The Market

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by: Long/Short Investments

Summary

The idea the money has a “velocity” or speed at which it circulates in the economy is a bit of a spurious concept.

Velocity more closely resembles the rate at which credit is formed in an economy.

Money velocity points to the notion that the US Federal Reserve will have trouble increasing interest rates to its 2.75%-3.00% expected target this cycle.

The velocity of money was designed to give an indication of how fast money is exchanging hands in the economy. Generically defined, it's the frequency at which one currency unit is used to purchase goods and services within a given period of time, or nominal GDP divided by the money stock.

There are also numerous definitions of the money supply. The main ones include M1, M2, and MZM (money with zero maturity):

M1

M1 defines the amount of currency in circulation, such as Treasury notes and coins, demand and checkable deposits, and any non-bank issued currency (e.g., traveler's checks).

M2

M2 includes M1 and adds on forms of savings, including money market deposits, savings deposits, and retail time deposits (under $100,000).

MZM

MZM includes everything in M2 plus all money market funds minus time deposits.

Increasing M1 typically indicates that consumption is increasing, and vice versa. Given how consumption as a percentage of GDP has increased over the years, M1 has increasingly followed the general path of the business cycle.

M2's inclusion of savings can allow economists to take its difference from M1 to determine the level of savings in the economy in absolute terms. The chart below shows increased savings in the economy over time, now in excess of $10 trillion.

(Source: St. Louis Federal Reserve)

As a percentage of GDP, this comes to 52.1%, up 21.1 percentage points over Q1 1995's 31.0% figure. This is a big deal given it means a lot of money isn't being spent and contributing to inflation and economic growth.

(Source: St. Louis Federal Reserve)

MZM includes M2 but adds money market funds and excludes time deposits.

The behavior of each over time is tracked below. (M2 and MZM are each multiplied by three to make their trending over time more visible.)

(Source: St. Louis Federal Reserve)

MZM's inclusion of money market funds has generated a fairly accurate predictor of inflation, which the graph below catalogues. (MZM velocity is multiplied by four to make its relationship with inflation more visually apparent.)

(Source: St. Louis Federal Reserve)

Velocity of MZM and CPI inflation share a +0.715 correlation going back to Q1 1959. M1 and M2 have virtually no correlation with inflation. Neither the velocity of M1, M2, nor MZM expressed as a ratio have any functional correlation with real GDP, nor are they expected to.

Correlation coefficient table

(Source: author)

What Money Velocity Actually Represents

The velocity of money is, in many ways, essentially the formation of credit. In a fractional-reserve banking system, a new quantity of money is formed whenever a loan is made, and the demand for lending is incentivized in the first place through the lowering of interest rates or policies such as quantitative easing.

Money velocity, as might be suggested, isn't necessarily how frequently a certain $1 bill exchanges hands in the economy through financial transactions. Hence the concept of money velocity spuriously suggests that its increase comes as a consequence of economic actors' increased willingness to spend the same amount of money at a faster pace. But that's not actually what's taking place. Rather, money velocity is more accurately a measure of the rate of credit formation.

If the product of the money supply, M, and the velocity of money (i.e., credit formation), V, increases - i.e., M*V - this will either increase prices, P (i.e., inflation), increase real output, Q, or both.

The relationship was first expressed by Irving Fisher back in 1911:

M*V = P*Q

P increases through an increase in spending. Q increases if the sum of productivity growth and growth in the number of hours worked in an economy increases.

One common criticism of central banks in recent years has been seemingly profligate monetary printing, or the idea that vast expansions of the money supply are inflationary. This is not correct, given that this money needs to be spent before it can influence prices and therefore inflation.

This is, for example, why Japan is expanding its money supply so rapidly. For demographic and other reasons, Japan has been fighting the ogre of deflation for nearly three decades. If the demand for lending remains low and credit isn't formed in sufficient enough quantities - i.e., a fall in V - then the Bank of Japan has no other option but to keep expanding the money supply, M, in order to keep M*V above its previous mark.

If M*V falls, deflation sets in. This is bad, given some low level of inflation is necessary to incentivize consumption, which is primarily how developed economies grow.

Holding all else equal, any increase in M that is effective in boosting spending beyond the market's embedded expectations is bearish for bonds (inflation increases, eating into yields) and bullish for stocks (companies can generally pass off higher costs by increasing the prices of goods and services).

Accordingly, any indication of where the money supply is going, and how the formation of credit might be impacted in conjunction, can lead to an understanding of where the economy and financial markets might go.

However, it depends on the measure of money supply. M1 and M2 velocity are not especially helpful in figuring out what markets or the economy may or may not do, as they themselves have no genuine relation to inflation or GDP growth, which are the fundamental statistical drivers of markets at the most macro level.

MZM velocity is a more pertinent figure given its inclusion of all money market funds minus retail time deposits, which essentially represent savings. If money is being saved, it's not being spent. And if it's not being spent, then it's not influencing prices and therefore inflation. MZM is basically a smoothed out representation of the trajectory of inflation.

Given that inflation is the primary determinant of interest rates (though it's subject to shifting over time), any decrease in MZM velocity (a proxy for credit demand/creation as a percentage of nominal GDP) is expected to coincide with a drop in equilibrium interest rates. Somewhat paradoxically, MZM velocity is already at an all-time low since the metric was first tracked despite a sub-1% nominal overnight rate.

In the case of the Fed, hiking rates is not congruent with the story told within MZM velocity. Rates should generally align with its pattern. Fighting against the trend will slow down a healthy pace of credit formation.

If we look at a chart of MZM velocity (x4) plotted alongside the effective federal funds rate, overly aggressive tightening in response to this variable has preceded each of the eight recessions that have occurred since MZM velocity has been tracked.

(Source: St. Louis Federal Reserve)

The Fed will find that any tightening it does will easily have an effect on the economy, largely due to high levels of global indebtedness. Raising rates during periods of high indebtedness makes debt servicing more challenging and diverts financial resources away from other initiatives. This puts downward pressure on the rate of credit creation and results in headwinds for growth and inflation.

While the Fed has been steadily revising down its neutral overnight rate since 2012 - going from 4.25% in 2012 to 3.00% today - it's possible that even the 3% figure is an overestimation. This is particularly true while 10-year yields hover at just 2.20%-2.25%.

If the Fed is overestimating the degree to which it can tighten monetary policy - and there's already about 200 bps of tightening factored into the curve over the next 2-3 years - and begins slowing its pace of rate hikes, this will diminish some degree of bullish bias currently embedded in the US dollar (NYSEARCA:UUP)(NYSEARCA:UDN). Any diminishment in the purchasing power of the dollar would expect to raise inflation expectations. This would expect to be positive for stocks (NYSEARCA:SPY), whose cash flows would be discounted at lower forward rate expectations.

Final Thoughts

MZM velocity is one such metric one can use to follow the general trend in inflation and, by extension, equilibrium interest rates. The global economy isn't generating much inflation due to high debt loads weighing down spending. This debt issue exists not just at a singular level of a particular economy, but the world as a whole. Then there is the additional challenge of aging demographics that undermine developed economies' ability to grow and achieve the income growth necessary to easily chip away at these debt loads.

Credit demand as it relates to nominal GDP is still relatively low largely as a consequence of these issues, and this in turn dictates that equilibrium interest rates should remain low as well.

The Fed is currently targeting another eight rate hikes over the course of the next 30 months, in addition to some degree of passive balance sheet run-off.

It's quite an about-face from what investors were expecting just 7-8 months ago when there was merely a 50% expectation of one rate hike for all of 2017, or an average expectation of 0.5 25-bp rate increases, let alone the current supposition of three.

The election results in the US last November suggested policies would be forthcoming regarding "reflationary" initiatives. However, effective enactment of tax cuts, some level of financial deregulation, and infrastructure spending, even if achieved to the markets expectations, won't outweigh broader factors that aren't eminently remedial (e.g., too much debt, burgeoning entitlement spending, economies not producing enough workers).

The goal of eight rate hikes by year-end 2019 and balance sheet run-off is probably too aggressive of a goal and would probably be a mistake based on what we expect currently. The risk in today's world economy is not overheating but rather disinflation, which means interest rates should remain low.

Consequently, the flip of the switch on policy expectations that largely came with the election results was mostly unwarranted. Any uptick in business confidence is positive for shorter-term considerations as it may pertain to the ongoing business cycle, but ignores important longer-term circumstances.

Raising rates at too high of a pace would reflect insufficient attention to these longer-term risks that simply aren't going to go away as a consequence of one administration's fiscal policy goals. Fed officials are likely to find that tightening monetary policy to their current intentions will slow growth, inflation, and money velocity (i.e., credit formation) more than expected.

This is not necessarily a near-term risk to stocks or financial markets more generally, but will increasingly skew risk/reward further to the downside.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.